Update on Dealing with Government Investigations in Audit Responses

IN BRIEF

A lawyer responding to an audit request should know of the September 2017 case Menaldi v. Och-Ziff Capital Mgmt. Group LLP out of the Southern District of New York.

A subpoena can be the basis for having to disclose a loss contingency under Accounting Standards Codification, but that isn’t always the case.

The effect of Menaldi when there is a subpoena that may be a harbinger for government claims likely will be to be prompt disclosure in more circumstances of a matter as a threatened claim, rather than as an unasserted claim.

In the fall 2016 issue of In Our Opinion, I wrote an article entitled Dealing with Government Investigations in Audit Responses that focuses on the SEC enforcement action against RPM International Inc. and its general counsel. A federal court subsequently denied the defendants’ motions to dismiss the SEC action. Sec. & Exch. Comm’n v. RPM Int’l, Inc., 282 F. Supp. 3d 1 (D.D.C. 2017). RPM involved a qui tam complaint against the company for violation of the False Claims Act. Although filed confidentially, the complaint was shared along the way by the government with the company, but the underlying potential liability was not disclosed by the company until later. The article also discusses Indiana Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016), which involved a company’s failure to disclose a government investigation regarding its overcharging the City of New York following indictment of two employees and threats for recoupment by the mayor of New York.

In September 2017, the U.S. District Court for the Southern District of New York in Menaldi v. Och-Ziff Capital Mgmt. Group LLC, 277 F. Supp. 3d 500 (S.D.N.Y. 2017), found that Och-Ziff did not comply with generally accepted accounting principles by failing to disclose, as required by Accounting Standards Codification 450-20, potential loss contingencies after it received subpoenas from the U.S. Department of Justice (DOJ) and the SEC relating to violations of the Foreign Corrupt Practices Act (FCPA). Although the court dismissed Rule 10b-5 claims against Och-Ziff for failure to disclose the potential loss contingency, finding that the plaintiff failed to adequately plead scienter, the decision could be read to indicate that receipt of a subpoena is sufficient to show a claimant’s manifestation of awareness of a claim. This shifts the standard for required disclosure (and potentially accrual) under ASC 450-20, as interpreted by the Second Circuit in SAIC, from being probable of assertion as an unasserted claim to being reasonably possible as a threatened claim. In my view, however, a proper reading of the court’s decision in Menaldi indicates that whether a subpoena is sufficient to show manifestation of awareness of a claim depends upon the particular circumstance, including what the subpoena indicates about a possible claim, and what the company knows of the underlying basis for that claim.

Menaldi was a securities class action lawsuit against Och-Ziff and certain of its officers and employees alleging various violations of the federal securities laws for failure to disclose improper payments and related government regulatory proceedings and investigations involving its mining activities in Africa. After Och-Ziff entered into a deferred prosecution agreement with the DOJ admitting violations of the FCPA and a settlement with the SEC under which it paid over $400 million as disgorgement, the plaintiff filed a new complaint that included a claim that Och-Ziff engaged in fraudulent financial reporting because it failed to disclose the potential financial impact of the government investigation as required by ASC 450-20.

The court analyzed the requirements of ASC 450-20 and found that Och-Ziff’s failure to disclose the FCPA investigation and its potential consequences was a violation of those requirements. The court, citing the SAIC decision, began with what it called the “threshold question” of whether there was a manifestation by the government of an awareness of a possible claim, shifting the applicable standard for disclosure from the “probability standard” to the “reasonable possibility standard.” The court acknowledged that the manifestation in this case was not as strong as in SAIC, but nevertheless found adequate allegations that the detailed subpoenas concerning its African ventures made Och-Ziff aware that there was an active investigation that could lead to the government’s filing of a claim against it, and that a loss was reasonably possible (i.e., in ASC 450-20 terms, that the likelihood of an adverse outcome was “more than remote”).

Although the court found that ASC 450-20 had been violated, it ruled that the plaintiff had not adequately pled scienter as a basis for a Rule 10b-5 claim, distinguishing SAIC where the defendant company received the results of its internal investigation, knew about the kickback scheme, and was aware of the potential fines and penalties and loss of contracts. Quoting from Godinez v. Alere, Inc., 272 F. Supp. 3d 201, 219 (D. Mass. 2017) (plaintiff adequately alleged that company had sufficient reason to know a product recall was likely so that it should have accrued or disclosed a loss contingency under ASC 450-20), the court stated that, “[T]he existence of a subpoena does not, without more, give rise to a strong inference of scienter on the part of senior management.” In finding as well the absence of reckless conduct, the court described ASC 450-20 in terms that should provide some comfort as follows:

ASC450 is not a ‘reasonably simple and straightforward accounting rule.’ . . . The rule requires many judgment calls in deciding how to respond to contingencies. . . . [T]his claim involves an omission that is based on a qualitative accounting rule rather than an affirmative misstatement about a pending investigation.

277 F. Supp. 3d at 516.

Thus, although a subpoena can be the basis for having to disclose a loss contingency under ASC 450-20, that is not always the case, and a more detailed analysis is required. One lesson from Menaldi is that a company is well advised to look harder at the need for disclosure when it has received a subpoena, and to accelerate internal efforts to determine if there is an underlying basis for claims related to the subject matter of the subpoena. A company may take some comfort in the ability to exercise judgment regarding the requirements of ASC 450-20 based upon the court’s characterization of that accounting rule. However, for a lawyer responding to an audit request, the effect of Menaldi when there is a subpoena that may be a harbinger for government claims likely will be to prompt disclosure in more circumstances of a matter as a threatened claim, rather than as an unasserted claim.

ABOUT THE AUTHOR

Stanley Keller is a nationally recognized corporate and securities lawyer based in Locke Lord’s Boston office. Stan has extensive experience in corporate and securities law and has worked on regulatory…